The Land Residual and Building Residual techniques of real estate valuation allow us to value either only the land (Land Residual) or only the building (Building Residual)  of an improved piece of real property. An “improved” property is simply a piece of land with something built on it, typically but not necessarily a building of some sort. It’s easy to mix them up so just remember that the item in the title – land or building – is what that technique derives a value for. The item being valued is referred to as the “residual” since both techniques start with a total value and then subtracts out the value of the land or building.

Land Residual

Without going into too much detail, the Land Residual Technique consists of three (very) general steps: value the property as improved (improvement/building + land); value the depreciated costs of the improvements using the cost approach; subtract the value of the building from the value of the property as improved. It’s easier to see the principle behind the Land Residual technique if you imagine a brand new improvement/building where we know the exact cost of development (keep in mind that the cost of development includes the actual costs of development incurred and a competitive contractor markup/developer return/entrepreneurial profit); for a new building a typical investor/buyer should be willing to buy a piece of land for the total value as improved less the cost to build and less a required return on his investment. This return, by the way, should be a going markup that the typical developer or contractor receives, otherwise we get into Individual Values rather than Market Values. If the building is not new the depreciation needs to be subtracted, and keep in mind this is actual depreciation as opposed to the depreciation calculated for tax purposes.

Why use the Land Residual Technique? The most common reason for using the technique is for valuing the land underneath an improved property in a neighborhood of improved properties; land sales in developed areas tend to be few and far in between. However, it could be that the land is non-conforming in some way that makes finding comparable sales difficult or impossible. Finally, developers contemplating substantial rehabilitation, demolition, or repositioning often utilize the Land Residual technique.

Another important thing to keep in mind is that the value of the improved property as-is and the cost to replace the current improvement should only be used if the current improvement satisfies the Highest & Best Use of the land, otherwise the value of the property improved to its Highest & Best Use and the cost to replace that particular (imagined) improvement should be used. You can imagine an improved piece of property with an outdated/inappropriate improvement; because the total value of the improved piece of property will be artificially low so will the value of the land.

Building Residual

The Building Residual technique is done in a reverse fashion: value the property as improved (improvement/building + land); value the site area using the Sales Comparison Approach; subtract the value of the land from the value of the property as improved. If the land underlying the improved property is similar to the comparable sales and is not adversely affected by the improvement in a fashion dissimilar to that of the comparable sales (soil contamination being a common example), the value of the improvements should be teased out if we subtract the value of the land from that of the improved piece of property.  Keep in mind that the resulting value will reflect the actual cost to build – depreciated for time – together with the contractor markup/developer profit.

Why use the Building Residual technique? The technique is often used to value buildings when depreciation is difficult to estimate. Also, for measuring the value loss to an improved property of its improvements, the Building Residual technique can be helpful. Also, if we had no good data on contractor markup/developer profit, the Building Residual technique would allow us to extract market data for such markup/profits.

Property Residual

So, if the Land Residual technique derives a value for the land and the Building Residual technique derives a value for the building, what value does the Property Residual technique render? The value of the entire property, that is the value of the land and its improvements. If you’ve ever estimated the value of a property through Direct Capitalization you have applied the Property Residual technique. Under this technique a single CAP rate is applied to the Net Operating Income (NOI) derived from that property without attempting to segregate income attributable to the land and income attributable to the building.

Using Residual techniques In the Income Approach

The Land Residual and the Building Residual techniques can also include isolating the Net Operating Income attributable to either the land or the building and then deducting that amount from the total Net Operating Income of the entire property; the residual income (the income attributable to the land under the Land Residual technique or the income attributable to the building under the Building Residual technique) is then capitalized with a CAP rate specific to either the land or the building – not the “blended” rate that would be applied to the total NOI under the Property Residual technique. The value resulting by capitalizing the income attributable to that item (land or building) is the value of that residual.

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Direct Capitalization

Most  newcomers to the vocabulary of commercial real estate will have heard about or have some basic understanding of what a “CAP” rate is. “CAP” generally refers to “Capitalization” (i.e. the process of converting income to value), and more specifically Direct Capitalization. They will likely also know that the equation for a CAP rate is: CAP Rate = Net Operating Income/Value (Net Operating Income divided by the value or sales price of the property).

For example, if you hear someone say that a property sold at a 7.00% CAP rate, they are saying the Net Operating Income of the property in the first year of ownership when capitalized at 7.00% yields the value/sales price of the property TODAY (by the way, the NOI used here is ANTICIPATED – it is an estimate of an NOI that will be realized one year from the date of purchase, so called “Year 1” of ownership).  In other words, the one year monetary yield of the property (the NOI in the twelve months of ownership subsequent to purchase) in relation to the sales price/value is 7.00%. You can think of this CAP as like a dividend, it measures the money the property “spits off” and does not take into account any appreciation or depreciation of the underlying asset.  Under Direct Capitalization only a single number is “directly” capitalized – the Year 1 NOI.

To reiterate, consider that the method of Direct Capitalization gives you the relation between a single year’s income (Year 1) and the value/sales price of the property. Direct Capitalization has nothing to do with anticipated resale value, income in the future, inflation, or anything else that takes place outside the scope of the first year of ownership and the price paid at the beginning of that period. Direct Capitalization reflects a one year return, it has nothing to say about the future. Therefore, to the extent that you believe CAP rates tell you something about how desirable an investment in property is, it is nevertheless a measure of its current desirability only.

Finally, also keep in mind that the CAP rate is a function of the marketplace. That’s why appraisers and brokers talk about “prevailing” CAP rates; real estate markets are typically deep and broad and buyers of real estate are usually price takers and pay something close to the prevailing CAP rate.  And so as to cut down on all the comments to the contrary, I concede that real estate markets are particularly inefficient and that this gives rise to many arbitrage opportunities. But still, buyers are still largely price takers when it comes to commercial real estate, no one buyer can really move the market.

 

Yield Capitalization

Yield Capitalization is heavily relied on in real estate finance and valuation because properties are long lasting typically; just as equities and bonds take into account the future of the underlying, long-lived corporation or borrower (bonds are debt instruments), so should a piece of real property be valued and priced with a thought towards the future.  Is it not conceivable that inflation could increase, rents could rise due to future capital expenditures like renovations, maintenance and repair costs could climb soon after you assume ownership due to insufficient investments by the prior owner, etc?

There are many factors like those above that are going to make your return on the property change from year to year.  But what about a total return for the entire holding period expressed in an annual rate?  In other words, wouldn’t it be superior to be able to calculate an anticipated, annualized average return for the property for the entire holding period of the property? Of course it would, which is why everybody from commercial real estate appraisers, to investors, to brokers, to regulatory agencies rely on Yield Capitalization, or the conversion of income over a period into a current value.  And instead of the CAP rate, the metric at the heart of Yield Capitalization is the Internal Rate of Return (IRR) (for a systematic explanation of how to calculate the Yield Capitalization rate, see Internal Rate of Return).

Before I go on, and to re-reiterate, I want the reader to consider for a moment how bizarre it is to value a multi-year investment based on a single year’s performance as is done with a CAP rate. Take equities for example: a common way to value stocks is to base the market value upon the anticipation of future years’ income back to the present. All aspects of the business get evaluated to help determine what those future cash flows will look like and both elements external and internal to the firm in question are assessed.  But the takeaway is that all this research is meant to paint a picture of the future, not just the present year. What if this one year period of evaluation was an outlier?

Or how about athletes? What ball club signs a multi-year contract with an expensive new recruit without consideration of his anticipated performance in the future? Who buys gold based only the present desirability of its price, without reflecting on the future prospects of gold? Even the late night TV crowd who buys gold does so because they hear everybody and their brother talk about the rising price of gold. Who looks at the spot price of gold (analysts aside) in exclusion and determines whether it’s too dear or a great buy? Why, then, would anybody buy a multi-million dollar piece of commercial property – which they anticipate holding for more than a single year – based on the performance of a single year? And for those investors who want to base the desirability of a property on last year’s performance (see In-Place CAP rate), the question is even more absurd: why spend millions of dollars on a property based on what happened in the past?

This brings us to the chief objection to the Yield Capitalization approach among those that swear by the CAP rate approach exclusively: “I won’t rely on the Internal Rate of Return because I know what happened in the past but nobody can tell the future!” That is, decisions based upon the past are supportable because there is a record of fact to consult; decisions about the future are purely speculative. Both statements are true, yet the desired inference from those statements is fallacious or at least incomplete; we have no guarantees the future will resemble the past (see Nassim Taleb) and while nobody can be 100% accurate about future events we can assign probabilities to events.  This is where bigger than a bread box and smaller than a jet airliner is actually of some use because at least we know it is bigger than a bread box and smaller than a jet airliner; to ignore that knowledge in your valuation is omitting precious information.

Also consider how silly it is to rely on past performance to the exclusion of what you anticipate to occur in the future. Anybody who bought real estate between 2002 and 2007 perfectly understands that past performance is no guarantee of future performance. Past data might be factual but its reliability lulls one into the trap that there is nothing new under the sun. In finance, at least, the past is certainly NOT prologue.

While nobody can be 100% accurate about future events we can assign probabilities to events. Let’s take a rather crude example to illustrate this point. A family is faced with the choice of buying season passes to Disneyland as they attempt to purchase a day pass only. The season ticket costs 25% more than only the day pass. Last year they went to Disneyland zero times. This year the family moved to a neighboring city (closer than their old home) and Disneyland has put in a handful of new rides and attractions. Also, the children tell their parents all their new friends at school frequently go to Disneyland as they are season pass-holders as well. Should the family purchase the season tickets? I don’t know, but you can see that the decision requires much more than simply considering their past behavior. Assuming they can afford both options and wish to save money, the answer will inevitably center around whether more frequent family visits in the future, as compared to the past, is MORE or LESS PROBABLE. The family can’t tell the future and neither can we, but we all make a million purchase and investment decisions based upon the probability of future outcomes.

“But I’m not an expert, and neither are you!” Let us consider this oft heard retort when you suggest to your investor client that they value a proposed acquisition based upon a period of time out into the future, aka through the Yield Capitalization approach. First of all, I’ll let Taleb try and convince you of the utter worthlessness of “expert” forecasters. But even if you believe “experts” are better able to predict the future than yourself (or your broker), you are still left with a sense of probability that constitutes information. If you decline to incorporate this knowledge into your investment decision process, you are doing yourself a real disservice. We don’t need an expert to tell us that an inflation rate of something more than zero is highly likely  (even in these near deflationary times); that multifamily rents are more likely to rise than fall due to limited construction and an increase in the renter population; that interest rates are likely to raise given that they are near zero now.

Direct Capitalization is convenient, but then so is the microwave. Take some advice and use it as a way to measure how expensive a property is in relation to similar properties currently, not whether it’s a good long term investment. For this, we look to Yield Capitalization. See Required Returns for more information on how an investor should value a proposed acquisition.

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Here are three very simple property valuation calculators intended for use by the California Probate Referee community.  There is a single family, land and commercial property calculator/appraisal report available for download.

Download them here:

Single Family Residence (SFR) Valuation Calculator and Appraisal Report

SFR_Valuation_Probate

Vacant Land Valuation Calculator and Appraisal Report

Land_Valuation_Probate

Commercial Valuation Calculator and Appraisal Report (Simple)

Commercial_Valuation_Probate ***IF YOU DOWNLOADED THIS PRIOR TO 04/12/2012, YOU NEED TO DOWNLOAD IT AGAIN

All of the workbooks are protected, but there is no password. If you would like to alter the models simply unprotect the worksheets.  Also, all items which are intended to be changed and which are dynamic are in blue. I do not provide support for these models, though if you find an error please bring it to my attention.

Though the intended user of these is a Probate Referee, the models still provide a pretty solid – if basic – calculator to make adjustments and reconcile a value. Enjoy!

 

 

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Every investor is entitled to their own Required Return, but not their own CAP rate!  Hang around a broker’s office for a day and you will inevitably hear real estate investors declare that they will buy nothing for less than such a such a capitalization (CAP) rate.  As in, “find me 50 units in Santa Monica and I require a 10% CAP or greater.”  This is akin to saying to your stock broker, “find me some Apple stock and I won’t pay anything more than $300 per share.” Apple was selling for just under $510 per share at the writing of this post (the examples aren’t perfect since real estate markets are even less efficient than equity markets, but it makes the point). “Good luck!”, the broker says as he rolls his eyes and moves on to the next lead.  The investor in question bemoans the lack of good brokers in the world and calls the next broker.

It’s too bad because nine times out of ten language is just getting in the way. Let’s take a look: CAP rates tell us how much investors are paying for a given stream of income, the Net Operating Income (NOI) of the property. Depending on the location and perceived risks of the property, investors will pay more or less for different properties with the exact same net income.  CAP rates are set by the market.  They exist irrespective of one’s Required Return.  Unless you are willing to make the seller an offer they can’t refuse, or unless the seller lives in a vacuum, expect to pay somewhere close to the prevailing CAP rate, all other things equal (condition of the property, quality of construction, rent control, etc).  Your broker can’t move the market, so as the investor put away the rolodex and contemplate the following: What is my Required Return on the Property?

A multitude of factors can change the Internal Rate of Return (IRR) – a preferred metric in real estate to measure a return for a given period of time. It is true that the purchase price is a significant component of IRR, but it is certainly not the only one.  The job of the investor is to find deals that meet or exceed their minimum Required Return, and unless the investor evaluates them over a realistic holding period they won’t know whether a  property meets their minimum Required Return.  Financing, rehabilitation, use, repositioning, new management, anticipated appreciation and like kind exchange are all examples of things that have a huge impact on Expected Return.

This Expected Return is what the investor is really interested in, whether they express it as such or not.  An investor should purchase a property when the Expected Return is equal to or greater than their Required Return.  It is your job as an investor to understand this and your job as a broker to explain this to your clients. Otherwise, everyone is  just spinning their wheels and talking at cross purposes.

If you are the broker, suggest the client look at the returns of large Real Estate Investment Trusts (REITs) or indexes of REITs. This should provide a good starting point for investors in determining their Required Return. After all, why should an investor go into business for herself and expose herself to individual, non-systematic risk for a return less than what she could get passively in the stock market? Believe me, clients will come up with all sorts of colorful answers, but financial orthodoxy would say they shouldn’t.  Then explain that the REIT return in question is measured over a period of time, whether it’s year to date, annual, or over a period of years.  Next, ask how long they expect to hold the property and look up the corresponding REIT return for a similar period of time.  Finally (and this is the hard part), explain that they need to look at the Expected IRR for a property and consider buying it if that IRR meets or exceeds their Required Return, as roughly approximated by the periodic REIT return you looked up.

Of course I entertain no illusions and am fully aware that many, if not a majority,  of investors not yet familiar with IRR or the concept of Required Return vs. CAP rate will be apprehensive and suspect given that they don’t grasp the concepts.  Many will tell you about how they don’t buy anything they can’t sketch out on a napkin, or provide some overly simplistic metric handed down from their parents/bosses, etc. (cash-on-cash anybody?), but it’s still incumbent upon you as a broker to exercise your fiduciary duty and explain accepted wisdom on the subject.

Note: A common source of confusion arises because many investors only have access to Proforma CAP rates or, rather, CAP rates as advertised by the seller based on a hypothetical Net Operating Income (NOI) in the first year of the new buyer’s ownership. Therefore, given a lack of reliable data, they simply choose a CAP rate they feel comfortable with and tune out the noise caused by widely varying Proforma CAP rates. Brokers, though, should have access to Market CAP rates through listing services and industry surveys.

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Alternative To Argus

February 2, 2012

I am proud to present this Multifamily Property Valuation Model in Excel DOWNLOAD THE MULTIFAMILY MODEL HERE: Multifamily_Valuation_Model_IPA_v1.8 VIEW AN EXAMPLE IN .PDF FORMAT HERE: Multifamily_Valuation_Model_IPA_v1.8.PDF *PURCHASE PASSWORD TO OPEN & MODIFY, $99.99 After payment has been received, a password will be emailed to you.   In a previous post, “Alternatives to Argus“, I discussed the pros and cons […]

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How to Calculate the Effective Cost of Debt (ECD)?

January 17, 2012

The interest rate that is reflected in a promissory note is the nominal rate of interest on a loan. From the borrower’s point of view, this nominal rate is the cost of converting the present value of money into its future value equivalent. Take the typical borrower for example: because she is unable to repay […]

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Should Equity Buildup Be Included for Calculating Real Estate Returns?

January 5, 2012

No. Equity buildup should never be calculated and folded into any of the prevailing methods for calculating a return (ROA, ROE, IRR, MIRR, NPV). In the industry, we refer to returns that contain equity buildup as a “broker’s return” or a “liar’s return”. I guess that these terms are synonymous should give you some indication […]

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Modified Internal Rate of Return (MIRR)

May 28, 2011

As I promised in the post titled “How to Calculate IRR After Financing”, I want to dedicate a post showing how and why Modified Internal Rate of Return (MIRR) is calculated. But before we delve into Modified Internal Rate of Return (MIRR), let’s briefly restate what Internal Rate of Return (IRR) is and is not. […]

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China’s Housing Prices Doubled in Last 3 Years

May 23, 2011

The Financial Times reports that there are 65 million vacant properties in China, prices have doubled over the last three years, total credit expanded by about half of GDP in 2009 and then again in 2010, and that real interest rates are negative (meaning it costs money to not borrow!). All these reminders a day […]

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U.S. Apartment Vacancies at Three Year Low

May 23, 2011

The Economist magazine reports that apartment vacancies are at a three year low in the United Sates. As foreclosures continue at a healthy pace economists expect those vacancy levels to fall further, at least until rising rents, stabilized prices and looser credit make home buying attractive again. More importantly – since vacancies have really nowhere to […]

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How to Calculate IRR After Financing

May 21, 2011

Remember that the Internal Rate of Return (IRR) is not a unique equation but is instead a process of iteration of the discount rate in the calculation of Net Present Value (NPV).  It is adjusting the discount rate in the calculation of NPV until a zero NPV is found; the discount rate of a series […]

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China Real Estate Activity Stalls

May 21, 2011

My sister-in-law and her husband flip condominium units in the Shenzhen/Zhuhai-area of southern China. Now might be a good time to exit their trades and get liquid. According to the UK-based brokerage Knight Frank, real estate activity in China’s major cities is declining. A combination of rising prices, tightening measures on mortgage credit, increased (planned) […]

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LA Makes Knight Frank Suggested Places to Buy

May 21, 2011

According to Knight Frank, a well respected global real estate brokerage, “The housing market in the city of angels is hardly flying high – real estate consultancy Marcus & Millichap predicts the number of completed apartments will hit a 16-year low in 2011. But nowhere is looking more ripe for recovery than the Wilshire area […]

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Real Estate Investing 101

May 20, 2011

Though my goal is to cover all aspects of commercial real estate, I tend to get into the minutiae of how to value and measure the performance of Income Properties. If I haven’t covered something you are curious about or you are just starting out and want a good overview at the “20,000 ft” perspective, […]

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Net Operating Income (NOI) – King of the Metrics

May 20, 2011

Net Operating Income is the single most important measurement in commercial real estate. Whether you have a single family residence that you rent out, or a ten story high rise, Net Operating Income (NOI) is the amount of income that goes to the owner of the property after expenses are deducted from income, but before […]

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Alternative to Argus

May 18, 2011

Visit my post “Cheap Alternative to Argus” to download the fully functioning Excel spreadsheet. Take a look at the attached .pdf to see the model I use instead of Argus: Property Valuation Model. This is a .pdf copy, the original is in Microsoft Excel. A popular “turn-key” computer program to develop Pro Forma is Argus, […]

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Former Blog

May 18, 2011

I just wnated to provide a link to my former blog where you might find a post on a topic you’re looking for. Please see my former blog at http://landonmscott.blogspot.com/

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Beware the Negative Leverage Deal

May 18, 2011

Would you take out a loan at a 7% Effective Cost of Debt (ECD) (interest rate +loan points+prepayment penalty)  to leverage the acquisition of an apartment building with a 6.5% CAP rate? If you did, you would be in a negative leverage deal – at least until rents rose faster than expenses and NOI increased to yield a […]

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Slight Decline in Stock of Distressed US Assets

May 18, 2011

It would appear that we’ve reached a point where newly distressed assets, or rather loans on real estate assets which are delinquent or being foreclosed on, are falling rather than rising for the first time since this financial crisis began. The following excerpt is from Real Capital Analytics: Please see Real Capital Analytics feed on the […]

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Major Decline in Apartment Construction

May 17, 2011

The Commerce Department released figures showing that new home construction fell to an adjusted 523,000 homes per year. This near-2009 level of home building was led by a major fall in apartment construction, which was down 28%. Also, per the Associated Press (AP) news wire, “In previous recessions, housing accounted for 15 percent to 20 […]

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